Buy Sell Agreements

Effective buy-sell agreements establish the terms, price and procedures for transferring a departing owner’s interest. A smooth ownership transition is important to the departing owner, his/her family and the remaining owners.

Many closely held businessesdo not make formal plans to transition the business in the event of the premature death or disability of a business owner, the lifetime transfer or sale of the business, or the retirement of one of the key business owners. Lack of planning can cause a business to fail because of the significant changes that are brought about due to one or more of these triggering events.

A buy-sell agreement is a legal contract between business owners that restricts the right of an owner to transfer his or her interest in the business to certain parties under specified terms. Such agreements may compel the parties to buy and/or sell the business interest under certain terms if a triggering event occurs. Some events that may trigger a buyout include death, disability, retirement, termination of employment, divorce, bankruptcy, creditors’ judgment against an owner, a third-party offer to purchase or loss of license in a professional practice.

Over the years many different varieties of buy-sell agreements have been developed and not all of them are suitable for every business. It can be difficult to determine which one will deliver good results for your business.

Types of Buy-Sell Agreements

Each type of buy-sell arrangement has advantages and disadvantages in any given situation, and some may be more applicable then others based on several factors. It is important to carefully consider the structure of the buy-sell arrangement to make sure it meets your needs. Buy-sell arrangements should be revisited on a regular basis to make sure that the current plan is still appropriate and meets the goals and objectives of the shareholders or partners. In addition, the business should be revalued on a regular basis to ensure the value set in the buy-sell agreement is accurate. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone.

The success of a business can grow to depend on certain individuals, turning their death, disability or retirement into a potential devastating event if adequate planning is not in place. Buy-Sell Plans provide the roadmap for one party to buy another parties business interest in those circumstances. Buy-Sell Plans allows for the orderly transfer of ownership due to an unforeseen event.

Benefits of Buy-Sell Agreements

Guarantee a Buyer. A buy-sell agreement benefits the selling owner’s family by providing a guaranteed buyer(s). The remaining owners are protected against the sale of a significant (or, worse yet, majority) interest to an outside investor.

Create Liquidity. Upon a business owner’s death, retirement, or disability, his or her family has a continuing need for cash to pay ordinary living expenses as well as any estate tax liability. Estate taxes are typically due nine months after the date of death. Selling a business under these circumstances can often result in the family receiving less than the fair market value.

Set a Fair Selling Price. A business valuation strategy that is determined while all owners are active can usually be negotiated on an arm’s-length basis. Once a business owner has left the business, negotiating a fair sales price is much more difficult for the owner (or the owner’s estate) because the remaining owners hold most of the cards.

Fix Value. A buy-sell arrangement negotiated at arm’s length ordinarily determines the valuation for estate tax purposes. This allows the owners to plan their estates and can reduce the risk of costly valuation disputes among business owners or upon estate tax audit.

Maintain Harmony. Because of the pressures of business ownership and everyday life, it is often difficult for owners of a closely held business to maintain friendships and camaraderie. Maintaining harmony becomes more difficult after the family (spouse and/or children) of a deceased owner enters the business. A buy-sell arrangement can protect the owners and the business from problems that arise when a deceased owner’s family joins the business.

Funding a Buy-Sell Agreement

Life Insurance. Purchasing life insurance on the lives of the business owners is one of the most common methods of funding a buy-sell arrangement. In addition to being cost-effective, a primary advantage of life insurance is that it makes cash available upon the death of an owner. Moreover, if the arrangement is funded with permanent life insurance, the policy’s cash value may be sufficient to fund a buyout at retirement. In a cross-purchase arrangement, life insurance is sometimes purchased on a split-dollar basis or with a bonus to mitigate the cost to the shareholder. It is also important to note that when a corporation purchases life insurance on the majority shareholder to fund an entity purchase buy-sell agreement, the proceeds of the life insurance can increase the value of the corporation for estate tax purposes.

Borrow Funds. If the business or its owners plan to fund a buy-sell arrangement by borrowing funds after the death or retirement of an owner, several problems can occur. The business or the remaining owners may have difficulty obtaining a loan after the death or retirement of a key owner. Even if the business (or its remaining owner(s)) is able to get a loan to fund the buy-sell arrangement, the ability to get additional loans, for expansion or working capital, may be dramatically diminished.

Sinking Funds. A buy-sell arrangement can be funded with a sinking fund in which earnings of the business are retained to fund the arrangement. If an owner dies soon after the arrangement is executed, this strategy will not enable the business to accumulate the necessary funds to fulfill its redemption obligation. Retention of assets in a C corporation can trigger accumulated earnings tax.

Installment Purchase. A buy-sell arrangement can be funded by structuring the purchase as an installment purchase. However, this strategy puts a strain on cash flow that can be especially dramatic when the interest being purchased belonged to a majority or key owner. Although the business may be pushed into a transition period during which profitability may be reduced, increased cash flow is needed to fund the buy-sell arrangement. Such a cash flow strain can result in business failure.

Valuation Methodology

An important consideration when structuring a buy-sell arrangement is the method by which the business will be valued (i.e., the “valuation methodology”). The following are several common methods of business valuation:

Specific Fixed Price. Shareholders fix the price periodically by arrangement. The primary disadvantage of this approach is that shareholders often fail to adjust the price for changes in value. If the price is not adjusted regularly, the purchase price may prove to be wholly unfair to the selling shareholder. Moreover, the IRS may disregard the actual selling price and attribute a higher value to the business interest. The primary advantage to this approach is that it is simple.

Book Value. Value is determined by book value on the date of death or on the close of the last fiscal year preceding the date of death. The primary disadvantage of this approach is that book value is seldom an accurate reflection of value because it (1) reflects depreciated historic (and not current) values and (2) ignores the entity’s earnings potential. The primary advantage to this approach is that it is simple.

Capitalization of Earnings. Value is determined by multiplying earnings by a capitalization factor. The capitalization factor is generally obtained by analyzing the price-earnings ratio of comparable businesses in the same industry. If this method is utilized, earnings over several years should be examined to alleviate the consequences of economic cycles. The primary disadvantage to this approach is that earnings of closely held businesses are often manipulated (through salaries) for personal tax planning purposes instead of the business needs of the entity.

Formula. Value can be determined by a combination of factors. It is not unusual for a sales price to be based upon both book value and capitalization of earnings. Sometimes, a combination of these approaches is incorporated into a formula to mitigate the disadvantages of each approach.

Appraisal. Value is determined by an independent appraisal at the time of sale. Sometimes an appraiser is agreed to in the arrangement. In other instances, both the selling shareholder and the remaining shareholders are allowed to pick an appraiser with the value being an average of the appraisals. This approach probably provides the value that most approximates fair market value. The primary disadvantages of obtaining an appraisal are that it can be expensive and that it can delay the settlement process.

Cut Throat. The purchase price is determined by the shareholders at the time of sale. A shareholder contemplating a sale will offer his or her shares to the other shareholders at a price determined by the offering shareholder. If the other shareholders do not purchase the shares at this price, the shareholder who made the offer must buy the shares of the other shareholders at this price. This approach sets a theoretically fair price. However, it favors the shareholder with the “deepest pockets.” It is primarily used for lifetime sales and usually in businesses owned equally (or nearly equally) by two individuals.

A well-drafted and adequately funded buy-sell arrangement is an important piece of a business owner’s succession and estate plan. Without a well-drafted buy-sell arrangement, a business owner (or his or her family) can lose much (or all) of the equity that the owner worked a lifetime to create. Not only is a buy-sell arrangement important to the family of a deceased shareholder, a buy-sell arrangement protects the interests of surviving shareholders by providing them with an opportunity to control ownership of the business after the death of an existing shareholder. An important aspect of buy-sell planning, which is sometimes overlooked, is funding. Without adequate funding, implementation of a buy-sell arrangement may not be possible. Because life insurance provides advantages not available with other methods of funding, it is a common method of funding a buy-sell arrangement.

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